Capital Comments

Paging Professor Phillips

Inflation should be increasing.  But it’s not.

Economist A.W. “Bill” Phillips was born in New Zealand but moved to Australia as a young man to continue his education.  He traveled to China, but had to flee the Japanese invasion in 1937, via the trans-Siberian railroad.  He arrived in England, but the war followed.  He joined the Royal Air Force and was sent to Singapore.  When Japan attacked Singapore he escaped to Java, but there his luck ran out and he spent the rest of the war in a Japanese prison camp.

And yet, A.W. Phillips is remembered today for a bunch of dots he drew on a piece of paper.  Maybe he preferred a quiet occupation after all those terrible adventures.

Phillips returned to England after the war and became a professor at the London School of Economics.  On a rainy weekend in 1958 he drew a graph that plotted inflation of British wage rates against British unemployment rates.  The dots sloped downward.  When unemployment was high, wage rates fell or grew slowly.  When unemployment was low, wage rates rose more rapidly.  The Phillips Curve was born.

The idea caught the attention of American economists, who substituted inflation of consumer prices for wage inflation. And, sure enough, through the 1960’s, as the unemployment rate fell from over 6 percent to under 4 percent, the inflation rate increased from 1 percent to 6 percent.

It turned out that the curve wasn’t stable.  In 1963 the unemployment rate was 5.6 percent and the inflation rate was 1.3 percent.  In 1990 unemployment was 5.6 percent but inflation was 5 percent.  The Phillips Curve had shifted.  But it still sloped downward.  When the unemployment rate rose from 5.6 percent to 7.5 percent in 1992, inflation dropped from 5 percent to 3.7 percent.

If low unemployment rates cause inflation to rise, and high unemployment rates cause inflation to fall, there must be some unemployment rate in between that keeps inflation stable.  Economists call this the “natural rate of unemployment” or (I kid you not) the “non-accelerating inflation rate of unemployment,” which we really do call the NAIRU (pronounced nay-roo).  It’s not been constant over the years, but it’s usually in the neighborhood of 5 percent.

When the unemployment rate is above 5 percent, the inflation rate should decrease.  When the unemployment rate is below 5 percent, the inflation rate should increase.

Which brings us to now.  The unemployment rate hit 5 percent in December 2015, and the inflation rate that month was 2.2 percent.  In April this year the unemployment rate was 3.6 percent, and the inflation rate was 2.1 percent.  Unemployment fell, but inflation did not rise.

Where’s the inflation?  Paging Professor Phillips!

Perhaps Professor Phillips would say, “Hey, my curve plotted wage inflation against unemployment.  That curve is working just fine.”  Wages have been rising faster since the unemployment rate dropped below 5 percent.  That’s what we’d expect.  If businesses want to increase production, they need to add employees.  If the unemployment rate is low, employees are scarce, and businesses bid against one another to hire them.  Wages increase.

Usually businesses will pass higher wage costs to customers in higher prices.  That’s why price inflation should rise with low unemployment.  Instead, inflation has been stable.  The Phillips Curve is flat.

One reason might be rising productivity.  Productivity is output per worker.  When employees are scarce and wages rise, businesses may adopt automation to increase production and meet consumer demand with their existing workers.  Productivity goes up.  Businesses can pay those higher wages out of the increase in sales, without having to raise prices.  Low unemployment leads to rising wages, then rising productivity, but not rising inflation.

In fact, productivity has been rising.  Productivity growth ramped up from near-zero percent per year in mid-2016 to 1.4 percent in the first quarter of 2019.  That may be why inflation has remained low.

The Federal Reserve pays close attention to Professor Phillips’ dots.  If productivity rises, inflation may remain low even at really low unemployment rates.  The Fed would not have to raise interest rates to slow the economy down.

As long as the Phillips Curve is flat, our expansion has a better chance to continue.

Author: Larry Deboer
Category: ,